Portfolio Management

for institutional investors

June, 2010

Bogdan Bilaus, CFA CFA Romania

Summary
Portfolio management - definitions; The process; Investment Policy Statement IPS; Strategic Asset Allocation - SAA; Tactical Asset Allocation - TAA; Securities selection - SS; Implementation; Performance and risk measurement;

Portfolio Management -definitions

Portfolio - an appropriate mix of or collection of investments held by an institution or a private individual.

Portfolio Management - the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk vs. performance.

Portfolio management the process Why?

Performance measurement; Improvement learning loop; Discipline; Risk control; Consistency; Continuity; Selling tool;

Portfolio management the process

Investment policy statement - IPS Strategic Asset Allocation - SAA Tactical Asset Allocation - TAA Security selection - SS Implementation trading and rebalancing Performance and risk measurement

IPS what & why

What: formal statement of portfolio objectives and constraints which governs decisions making Why: It is an agreement between the owner of the portfolio and the manager, defining the general terms of service; It is easily transportable ensures continuity in case of manager change; Promotes long term discipline; Keep the portfolio in line in cases of panic and overconfidence;

IPS - content
client description; objectives; constraints; asset allocation and deviation limits; guidelines for adjustments and rebalancing; duties and responsibilities of the parties involved; schedule for both performance and IPS review;

IPS - objectives
Risk objectives Define the amount of risk to which portfolio will be exposed

Return objectives differentiate between required and desired; differentiate between real and nominal return; differentiate between pretax and after tax return; must be consistent with risk objectives and market conditions;
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IPS - constraints
liquidity expected or unexpected cash outflows to be met at some point in time; time horizon; tax concerns; legal and regulatory factors; unique circumstances;

Strategic Asset Allocation

The process that establish the weights of asset classes in total portfolio; Conscious effort to gain exposure to the desired level of systematic risk; Combining capital market expectations with the investors risk & return objectives and constraints long term in nature dynamic vs. static SAA asset-only or asset liability management approach;

SAA how?
Asset Class Equities Fixed income Money market TOTAL Expected risk 20% 10% 3% ? Expected return 25%% 11% 8% ? Weight ? ? ? 100% Allowed deviations +/- x% +/- y% +/- z%

Inputs: asset classes, expected risk and return, correlation matrix, constraints (short selling etc) Process: mean variance optimization; (alternatives: Black Litterman model, Monte Carlo simulation, etc;) Output: set of all possible portfolios (weights) with maximum return for any given risk level (or minimum risk for any given return level) = efficient frontier

Tactical Asset Allocation - TAA

Form of active management, when the portfolio managers deviate from SAA in order to take advantage of any perceived short term opportunities in the market.

Deviation from SAA introduces the risk that portfolio could return less than the SAA portfolio (benchmark), so this risk should be rewarded by additional return (over the benchmark return)

How: trading, derivative overlay

Security selection - SS
Deciding the structure of one asset class within the portfolio/ setting the so called model portfolio for each asset class / selecting form the investment universe the securities which will be included in the portfolio; Factors to consider liquidity; diversification vs. crowding effect; valuation; top down vs. bottom up;

SS - valuation
Sources of research: brokerage houses vs. independent research vs. own research Valuation methods
Discounted cash flows (DCF) discounted dividend model (DDM); free cash flow to the firm (FCFF); free cash flow to the equity (FCFE;) Peer comparison based on price multiples P/E; P/B; P/S;

Implementation trading
TAA + SS => % weight of each security within the portfolio;
Trading principles: long term price movements are determined by fundamentals; short term price movement are driven by changes in supply and demand, emotions, market sentiment, one off events etc; Recommendation: select securities based on fundamental analysis, enter or exit the market based on technical indicators; Diversify strategies: fundamental with technical overlay; Trading costs: fees; price impact; opportunity cost;

Implementation whats next?

do nothing buy an hold;

rebalance constant mix strategy; rebalance constant proportion portfolio insurance CPPI;

Rebalancing - constant mix strategy

Why? divergent price movements; cash inflows or outflows; changes in asset allocation (SAA or TAA) changes in stock selection; to maintain the desired risk exposure to systematic risk factors; How? calendar rebalancing; percentage of portfolio rebalancing;

Rebalancing - CPPI
Protects the portfolio against adverse market movements. Protection comes at the cost of lower participation to market rallies (<100%) % in risky assets (i.e. equities) = m * (TA-f)
CPPI
110

100

90

80

70

60 10/07

11/07

12/07

01/08

02/08

03/08

04/08

BET

CPPI

Performance - definitions
Absolute return vs. relative return return of SAA = benchmark Alpha the portfolio return in excess of the benchmark return
Performance analysis performance measurement; performance attribution; Sources of alpha: tactical asset allocation; stock selection; market timing trading;
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Performance attribution example

SAA Benchmark TAA BET return (benchmark) Model portfolio return (SS) Cash return Equity return Portfolio return alpha asset allocation stock selection market timing 100% equities 100% BET 85% equities / 15% cash 20% 30% 0% 35% =85%*35% + 15%*0% = 29.75% = 29.75% - 20% = 9.75% = -(15%*20%) = - 3% = 85%*(30%-20%) = 8.5% = 85%*(35%-30%) = 4.25%
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Risk measurement
Absolute risk indicators Variance / standard deviation / value at risk; maximum drawdown; Relative risk indicators tracking error; Risk reward indicators Sharpe ratio; Information ratio;
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Q and A

bogdan.bilaus@rzb.ro